Week 4

Question 1

what is a consumption bundle (basket of goods)

Answer 1

a complete list of quantities for all available goods

Question 2

describe preferences

Answer 2

• if bundle A is strictly preferred to bundle B, then: A > B
• if bundle A is weakly preferred to bundle B, then: A ≥ B
  -if the individual is indifferent between A and B, then: A ~ B

Question 3

what assumptions do we make about individual preferences

Answer 3

• completeness: for any pair of available consumption bundles, the individual can say they strictly prefer one over another
• transitivity: for any three consumption bundles x,y,z; x>y and y>z implies x>z
• reflexivity: for identical consumption bundles,
  there is no strong preference for either of them: X ~ X
• non-satiation: more is better than less

Question 4

describe the utility function

Answer 4

• U(X), assigns to each consumption bundle an index number of happiness (=total utility)
• for any 2 consumption bundles utility function can be used to extract individuals preferences
• ie/ if U(X) > U(Y), individual strictly prefers bundle X to Y

Question 5

describe ordinal utility

Answer 5

only the ranking of utility levels has a meaning, difference between utility levels is meaningless
- U(A) = 20 and U(B)= 40 does NOT mean that the individual prefers bundle B twice as much as A

Question 6

describe indifference curves

Answer 6

• L shaped curve
• if neither prefer X to Y nor Y to X, indifferent between X and Y and derive same utility from both bundles U(X) = U(Y)
• all bundles that leads tot he same utility lie on the same indifference curve
• there is one indifference curve for each utility level
• higher utility then lie further outwards from the origin
• curves cannot cross

Question 7

describe marginal utility

Answer 7

additional utility generated by an additional unit of the good holding the quantities of all other goods constant

Question 8

describe diminishing marginal utility

Answer 8

as an individual consumes more of some good, the additional utility gained from an additional unit of consumption decreases

Question 9

describe trade offs

Answer 9

holding utility constant, how much of one good a consumer will give up to get a little more of another good

Question 10

describe marginal rate of substitution

Answer 10

measures how many units of good 2 the individual is willing to give up for 1 additional unit of good 1, such that utility remains constant
- MRS1,2 = MU1/MU2

Question 11

describe budget constraints

Answer 11

individuals have money income or a budget to finance consumption; denote this budget by m (assume no savings)

Question 12

describe budget sets

Answer 12

consists of all bundles satisfying the budget constraint

Question 13

describe budget line

Answer 13

consists of all bundles that exhaust the consumer’s income

Question 14

describe optimal consumption bundle

Answer 14

feasible consumption bundle that maximises the consumer’s utility

Question 15

describe rational spending rule

Answer 15

if consumption bundle (x1,x2) maximises the utility of an individual, given her budget set, then it satisfies the condition

• MU1/MU2 = MRS = P1/P2
• MU1/P1 = MU2/P2